Benefits and Drawbacks of Currency Pegs

Benefits and Drawbacks of Currency Pegs

Advantages of Currency Pegs

In the post-Bretton Woods financial environment, currency pegs have gained enormous popularity. Approximately one-fourth of all nations in the world now have their currencies linked to another significant currency, such as the dollar or the euro.

Some countries, like Argentina, have gone bankrupt as a result of this strategy, but other countries, like China, have had economic success. As a result, this technique has certain benefits as well as some drawbacks. The advantages and drawbacks will both be mentioned in this essay.

Stable Basis for Planning

Currency pegs give governments an incredibly secure foundation on which to organise their finances. Governments are required to purchase necessities like oil and food grains on the global market. In this case, the government must use foreign money to cover its costs. Since the US dollar is the world's reserve currency, it is typically used as this foreign currency. Today, however, the international market also accepts other currencies, such as the Euro.

However, whether the Dollar or the Euro is utilised, the problem still exists. The government must use the Forex market to exchange its own currency for another. The government cannot predict how much of its own cash it will need to convert to foreign currency and meet demand if exchange rates are continuously shifting. Contrarily, currency pegs fix the rate and give governments a secure foundation on which to plan their income and expenditures in local currencies without having to worry about fluctuating exchange rates.

Discreet and Reliable Monetary Policy

Currency pegs are frequently used in third-world nations. In the past, impoverished nations in South America, Asia, and Africa have utilised currency pegs. This is due to the fact that these developing nations are also havens for corruption. As a result, these nations don't trust their regional leaders to manage their monetary policies. There is a good likelihood that the individuals in charge will ultimately bring about hyperinflation. President Robert Mugabe of Zimbabwe is an example in point, as he essentially destroyed the Zimbabwean currency for personal gain.

Therefore, these countries desire to delegate their monetary policy to a more advanced country whose decision-makers would be more responsible. The threat of political sabotage from the neighbourhood is only slightly mitigated by this. This is so that they may continue to order the inflation-causing creation of money. When a currency peg is being adhered to, they cannot, however, lower interest rates and create a bubble in the economy at large.

Reduced Volatility

In addition to the governments, local companies also benefit from currency pegs. The pricing of their products on the global market can be predicted by local enterprises. They can forecast the quantities that will be demanded at that price once they are aware of the precise pricing. As a result, they don't experience any volatility and are protected against currency losses. This gives them a significant advantage over rivals who must take on similar risks and must consequently factor a risk premium into their prices.

Disadvantages of Currency Pegs

• Increased Foreign Influence

On the other hand, nations that adopt a currency peg see increasing foreign meddling in domestic affairs. This is so that another country can control their monetary policy. This frequently results in a contentious situation. Take the attack on the pound sterling as an example. The British government had fixed its currency at the German Deutschemark at the time. German Bundesbank raised interest rates in response to domestic inflation worries. The British desired falling interest rates. The rates didn't go down, though. As a result, the British pound suffered greatly as the Bundesbank gained more authority over the country's internal affairs and the Bank of England lost control over its affairs.

• Difficulty in Automatic Adjustment

A floating exchange rate system causes deficits to be automatically corrected. For instance, a country will incur significant costs if it imports excessively. This will cause their economy's money supply to decline, which will result in deflation. Low prices due to deflation make their exports competitive.

So an increase in imports always results in an increase in exports! The system that is floating freely tends to reach equilibrium. But currency pegs frequently exaggerate the state of disequilibrium. Take into account the fact that a peg between the dollar and the yuan is to blame for the significant current account and trade imbalances between the United States and China. As a result, pegged currencies are more likely to experience disequilibrium. In the brief economic history of freely floating currencies, this has occurred on a number of occasions and is predicted to continue on a number of occasions in the future.

• Speculative Attacks

A currency can only be the target of speculative attacks if it deviates too far from its value. The currency that is allowed to float freely rarely deviates too much from its value. When a deviation occurs, the market mechanism immediately kicks in and causes a correction. On the other side, currency pegs can permit a significant disparity between a currency's inherent worth and its market value. This is a result of the Central Bank's attempts to control the value artificially.

There are some wealthy financial institutions that can even compete with central banks, and such instances have occurred frequently. Speculators have been able to effect devaluations on currencies when they strayed too far from their core value. Additionally, speculative attacks can occasionally be so strong that nations are forced to abolish currency pegs and allow their currencies to freely float within a few days. Every time one of these attacks takes place, the average citizen of the nation loses more money because both foreign trade and foreign investments are severely impacted.

An already-floating currency is significantly less vulnerable to such an attack. Therefore, this might be viewed as a key drawback of currency pegs.